The Earnings Estimate Divide

The stock market has rebounded the past three months on reduced risk, increased liquidity, and signs of improvement in the economic trends.  Unfortunately, the earnings outlook has not improved nearly to the same degree.  This suggests the market rally should be viewed with skepticism.

The Obvious

The S&P 500 index hit a low of 667 in early March.  It closed Friday, June 19, at 921.  This is a 38% rebound in a little over three months.

There are legitimate reasons for this rebound:  the downside risks to the economy have eased, the Fed has flooded the market with liquidity, and investor confidence has improved.

The most important factor in determining stock values, however, has not improved beyond a reasonable doubt.

Earnings Estimates

Two months ago, the 2009 bottoms-up operating earnings estimate (adding all the estimates company by company) for the S&P 500 was $79.09, according to Standard & Poor's.

Today, it is $55.81 for 2009.  For the forward four quarters of the second quarter of 2009 through the first quarter of 2010 it is $62.37.

Two months ago, the top-down earnings forecast (making economic assumptions and then backing out total earnings projections) for the S&P 500 was $45.78.

Today, it is $43.03 for 2009.  For the forward four quarters of the second quarter of 2009 through the first quarter of 2010 it is $44.00.

In other words, the market rebound has occurred despite any improvement in the earnings outlook as forecasted by Standard & Poor's.  Granted consensus estimates have risen from their nadir, yet the earnings outlook itself hasn't improved from where it was just two months ago.

Other Problems

Two months ago, the Big Picture column noted that there was a huge difference between operating earnings estimates for companies and as-reported earnings estimates.

This is because the as-reported earnings include all charges.  Those charges have been, and are expected to continue to be, quite large.

The as-reported earnings estimate for the coming four quarters is $31.07.

This compares to the operating earnings estimate noted above of $62.37.

This is a huge difference.  Companies are expected to report continued large one-time charges.  The "quality" of earnings in the operating earnings reports that are the commonly cited reports is extremely poor.

Valuation

Stock market valuations based on these earnings estimates are not good.

The price/earnings multiple of the S&P 500 based on current operating earnings is 16.1. (This calculation is based on expected second quarter operating earnings of $14.31 annualized to $57.24.  It makes little sense to include historical earnings which previously included massive losses at GM, as the company is no longer in the index.)

A P/E of 16.1 on current earnings is not too bad given a low interest rate environment.  It could be used to argue that the market is reasonably valued.

The problem comes when the as-reported earnings are taken into consideration.  The estimate for second quarter as-reported earnings is just $6.46.  Using this more encompassing measure of earnings leads to a current P/E calculation of 35.6.

This measure suggests that stocks are overvalued.

Using the forward four quarter bottoms-up operating earnings, the P/E is 14.7.   Using the year-ahead as-reported earnings, the P/E is 29.6.  Using the year-ahead top-down operating earnings estimate, the P/E is 20.9.

What it All Means

The stock market rally based on economic data that are showing a slower rate of overall decline should be viewed with skepticism.

Until there are indications that the economic data will improve sufficiently to lead to credible increases in earnings expectations, the stock market will have a difficult time posting significant further gains.

Furthermore, the current earnings outlook reflects a high degree of optimism by individual analysts making company-by-company forecasts.  This optimism is not shared by the market strategists that look at overall economic conditions and from that derive earnings forecasts.

Individual analysts are far too frequently vastly overly optimistic.  If the broad market strategists are right in their top-down forecasts, the stock market is highly priced.  This would mean that specific company earnings forecasts will come down over time.

Second quarter earnings reports will start coming out in about three weeks.  Those reports will provide a better indication of whether the so-called green shoots in the economic data provide legitimate hope that earnings will start ramping up later this year.

Right now, the stock market is reasonably priced based on the optimistic operating earnings forecasts.  Any concern about as-reported earnings, or any indication that the strategists' top-down estimates are more accurate, could lead to a re-evaluation of the recent market rally.

--Dick Green, Briefing.com